November 2012

With the market fluctuating significantly right now, the ability to spot trend changes early is critical. Here's an updated re-print of an article I wrote back in 2003 that is still very relevant almost 10 years later. It's about using our Scan Engine to find divergences - situations where one stock is going up and another is going down (or vice versa). Enjoy! - Chip

Scanning for Emerging Divergences

One of the most important technical signals to watch for on any chart is a divergence. Simply stated, a divergence occurs when prices move in one direction (up or down) and an indicator based on those prices moves in the opposite direction.

Divergences signal impending changes in the direction of a stock's price. They come in two flavors - "positive" (AKA "bullish") and "negative" (AKA "bearish"). A positive divergence happens when an indicator starts moving higher after prices have been in a downtrend (a potentially bullish development). A negative divergence occurs when an indicator moves lower while prices are still rising and is a bearish warning signal.

Any oscillating indicator can be used in a divergence study. Popular choices include the MACD, Stochastics, and Wilder's RSI. Many people also use indicators that include volume information - Chaikin's Money Flow for example - since price and volume often diverge at key turning points.

Unfortunately, like many things in the field of technical analysis, spotting divergences while they are still forming can be tricky. The biggest problem is distinguishing between a real divergence and just random "noise" on the chart. Just because a stock moves up for two days while its RSI (for example) declines, it doesn't necessarily mean that a significant divergence has developed - yet.

Often, peak-and-trough analysis is used to find divergences. If, for example, two or more rising troughs appear on the price plot (an uptrend), while two or more decline peaks appear at the same time on the indicator graph (a downtrend), a bearish divergence has been identified. This is how divergence is often taught in textbooks.

As with all forms of peak-and-trough analysis, there are two key problems with this approach. The first problem is that clear trendlines take time to form. The underlying trading opportunity associated with the divergence may be over by the time an unambiguous picture appears on the chart. The second problem is that identifying significant peaks and troughs is often very subjective - one person's significant peak is another person's random spike. For these reasons, peak-and-trough divergence detection is hard to automate (i.e., you can't create scans for it) and it is best used for finding exit signals for existing positions.

Simple divergence scans can be created by selecting (somewhat arbitrarily) a time duration (5 days for example) and seeing if prices have increased by more than a given percentage while the associated indicator has decreased by a different given percentage. Here's a sample scan that uses that technique:

In this example, the price must have increased by at least 2.5% over the past five days, while the MACD value must have decreased by at least 8%. (Note: The advanced scan interface must be used because a function of a function (i.e., AbsVal of the MACD) is needed.)

While this technique is easy to program into a scan engine, its results are hit-and-miss. Many of the charts returned by this kind of scan are not really experiencing a negative divergence. A visual review of all stocks returned by this kind of scan is a necessity.

A different technique is to use the Min and Max functions to ensure that we are at the highest (or lowest) point on the chart for a given time duration. If the stock's price is higher than it's been in the past thirty days (for example) and the indicator is currently lower than it's been during that same period, there's a good change a divergence is occurring. Here's a sample scan that uses that technique:

In that example, we're looking for stock that closed higher than the highest close during the previous thirty days and that had a Chaikin Money Flow (CMF) reading that is currently lower than the lowest reading during the previous thirty days. Here's one of the charts that this scan returned for me today:

If I was an SLH shareholder (and I am not), I'd be concerned because the weakening CMF line calls into question the strength of the current uptrend.

This technique is not fool proof either and also requires visual inspection of the results. While no divergence scan is perfect, the two examples above are good starting points and can be customized to suit almost anyone's trading style. I encourage you to study them closely and incorporate them into your stock hunting toolkit.

On the weekly chart below, we can see that, after making a new, all-time high back in August of 2011, gold went into a correction/consolidation mode, ultimately forming a descending triangle. While this formation suggests lower prices (the flat line is the weakest), price broke up through the top of the triangle. After a breakout the technical expectation is for price to pull back toward the line, which it did enthusiastically.

After testing that support, price has reversed upward, and this week made a strong move upward, signalling that the rally that began this summer is probably resuming. The weekly PMO (Price Momentum Oscillator) turned up again, which is a very positive sign.

Conclusion: Gold has completed its post-breakout pullback and appears to be resuming its long-term advance, but this will not be "official" until the October top is exceeded. It needs to overcome resistance in the area of 1800, and finally the resistance at the all-time high around 1900.

Overall, the world couldn't be more of a sovereign wild card. But at its weakest point, sometimes the strongest investment time is at the point of most change. While I don't forecast a quick turn, what can each investor watch for to see a global improvement? I'd like to propose the following chart could really help us.

The USA just elected a president. China just elected a new leader. Europe appointed a new ECB chairman. Japan has an election coming soon with a new leader trying to push for a plunge in the Yen. That is usually bullish for the stocks there. Germany and London have traded well. Australia has as well. Here is why I don't want to sing a bearish tune for the long term. This chart looks excellent from a basing point. Notice the rising MACD lows while the price continues to decline. What would make a more obvious choice to start climbing than the change of leadership? It doesn't appear to be done falling yet but it is at a very interesting time.

If China can make a bullish turn here that would be important. Today, the Shanghai continues to test support at 2000. The blue line at the bottom of the chart is flat at 2000. From the 2 year chart above, lets look at the 12 year chart below.

I would suggest a couple of interesting levels here. 2135 did not hold, but notice the scale levels as we go lower. Each about 5% below 2135. We currently sit near 2000. Just below this are levels at 1895, 1775 and 1665. Notice the coiling of the MACD. It is building energy here for a surge on the breakout. I didn't want to put too many lines on this chart, but an argument for a bullish wedge can be made from the 2009 high. It is called a bullish wedge because the distance between high and lows get narrower and narrower as the price falls. This creates a downward trend line on the top that has a more aggressive slope down than a trend line under the lows that has a less aggressive slope. Usually the break above the upper trend line would be fuel for a significant rise as the short positions have to cover quickly which also propels the price higher.

The Rydex Cash Flow Ratio gives a view of sentiment extremes by using cumulative cash flow (CCFL) into Rydex mutual funds. It is calculated by dividing Money Market plus Bear Funds CCFL by Bull Funds plus Sector Funds CCFL. (To read more click here.) While the Ratio shows that Rydex investors are becoming more cautious, deeper analysis of CCFL components shows that the bears are still reluctant to engage.

The following chart of the Ratio shows that sentiment has been becoming less bullish, and the Ratio has reached a level that marked an important market bottom in June. If the bull market is still viable, we could be near an important low.

Looking deeper into the composition of the Ratio, the chart below shows that cash has been flowing out of Bull and Sector funds, and it has been flowing into the Money Market Fund. Virtually no cash has moved into Bear Funds in the last three months. The bears are in hiding.

Conclusion: Earlier this week we observed that Investors Intelligence percentage of bulls has become significantly smaller, but the percentage of bears has not increased to a level we would normally see at an important low. The Rydex Cash Flow Ratio confirms that observation.

Important bottoms can appear when we don't expect them, so we will not be so bold as to say it can't happen about now; but bottom picking is a dangerous game, and we would want to see the bears becoming much more aggressive before we seriously begin to expect an end to this decline.

There is quite a bit of newsprint lately regarding the US "fiscal cliff"; and the impact of whether it goes through or not. Regardless or not of whether it is extended or not, we think it instructive to analyze the consumer discretionary stocks as they will be inordinately impacted.

First, let us state that since the 2009 bottom, consumer discretionary stocks have rallied rather strongly through the halcyon days of the mortgage "cash out" period in which money were flowing towards all sorts of goodies. Thus, we were rather surprised at the veracity of this rally given the end of the housing bubble and the negative impact of the "cash out" refinancings. If fact, the current rally has continue to levels were never thought possible. However, there are there, and now we believe they represent an opportunity to be short a number of names int he group, or via the S&P Consumer Discretionary ETF (XLY) itself.

Second, the technical situation has begun to show signs of breaking down. The rising trend-line off the 2009 and 2001 lows was just violated, which should allow prices to plumb towards lower levels and into major support at the 120-week moving average rising towards $40.00. However, we would posit the decline will be deeper into the shaded area as this represent prior low and high support, as well as the 38.2% retracement moves. Too, the 200-week moving average crosses inside of it. This grouping if you will tends to act like a magnet - especially given the 30-week stochastics has formed and confirmed a negative divergence. Also, note the distance above the 120-week moving average in the PPO frame; it hit just above 20%, whereas in the past this has proven to be extremely good resistance.

Collectively, we would say that all the moons are lining up for traders to start exiting Consumer Discretionary shares and buying other sectors that have better defined risk-reward parameters. Certainly at TRR we will be putting our our recommendations for short positions soon; and perhaps acting upon them as well.

All the recent talk has centered around the effect of a potential fiscal cliff. While we may or may not be subject to a fiscal cliff, each and every one of us has been subject to the recent technical cliff, especially the one since election day. Things have gone from bad to worse in the past couple weeks. We did see a series of potential reversing candlesticks print on Friday across our major indices, sectors, industry groups and leading individual stocks, however. Will that be enough to turn the table on the bears? Or will this simply turn out to be a temporary halt to the selling before another leg lower?

Take a look at the hammer that printed on the NASDAQ on Friday:

Short-term, the Friday reversal appears to be good news. The daily MACDs that are sprinting lower carry a much more ominous sign, however, as they're screaming at us that the momentum remains firmly in the bearish camp and any short-term upside move will likely be just that - a short-term one.

There was much talk last week that sentiment had turned decidedly negative and that was pushing our major indices lower. Ummmmm, I respectfully beg to differ. In fact, I'm not sure what to make of the Volatility Index (VIX), which generally moves inversely to the S&P 500. During market selloffs like the one we've seen lately, the VIX normally surges, reflecting the increased nervousness in the market. But since election day, while the S&P 500 fell more than 5% over six trading days, the VIX also fell - more than 10%! Check out the chart:

A lower VIX indicates the market is expecting lower volatility ahead. If you study history, you'll clearly see that a falling VIX is synonymous with a rising equity market. This begs two obvious questions. First, will the VIX surge near-term to play "catch up" with falling equity prices? Or is it telling us something about the duration of the wicked selling we've been experiencing - that it, in fact, won't last?

In the days and weeks ahead, we're going to learn more about both the fiscal cliff and the technical one. Please be cautious and keep your stops in place.

All sectors are down over the last two months, but some are down less than others. Of the nine sector SPDRs, the Consumer Staples SPDR (XLP) and the Healthcare SPDR (XLV) are holding up the best. Relative strength in these two defensive sectors confirms that the market is currently in risk-averse mode. The chart below shows the Healthcare SPDR declining the last five weeks with a falling channel. This channel defines the downtrend and prices need to break the channel to reverse the downtrend. Even though we have yet to see a reversal, there are signs of support as the ETF nears the August consolidation and the 50% retracement. Also notice that XLV led the sectors on Friday with the biggest bounce - although the bounce was rather modest. The indicator window shows the Commodity Channel Index (CCI) moving lower since early September. A break above the red trend line and a move into positive territory would signal a bullish reversal in momentum.

It's a question I get everywhere I go. After every talk I give, someone comes up and asks "What's the one market indicator I should watch to see where things are headed?" Many years ago that question gave me fits. In my brain I'd immediately have 1,000 thoughts: "There are so many indicators to choose from" and "Each indicator is interpreted differently" and "What if there are conflicting signals?" and "What if the NYSE changes its membership?" and... You get the picture. Needless to say, the answer that came out of my mouth back then wasn't pretty, or easy to understand.

Now the answer is simple: The NYSE Bullish Percent Index - period.

I've written extensively on Bullish Percent Indexes (BPIs) before. If you are not familiar with them, please click here to learn more. The NYSE BPI ($BPNYA) is the "granddaddy of them all" and is one of the broadest BPIs we publish. On numerous occasions in the past, it has been a leading indicator for the market and it always deserves periodic attention from serious ChartWatchers.

So what is it telling us now?

Click the chart for a live version.

Well... the picture is not promising for a continuation of the long-term uptrend that started in 2009. The chart shows that, just like it did during the previous uptrend that went from 2002 to 2007, the NYSE BPI is breaking down and diverging from the S&P 500 index. Recently the index tried and failed to rise back above the 70% level. That failure is significant because it continues a trend of lower peaks on the chart going back to the start of 2011 and creates a clear divergence with the S&P's uptrend.

A similar situation occured in mid-2005 when the index failed to stay above 70 (and then failed again twice in 2006) .

Now that the divergence with the S&P is clearly established, any significant weakness in the NYSE BPI should be taken as a warning sign. Conservative investors may watch for a move below 40. That would have gotten them out of the previous uptrend just after the start of 2007. Aggressive investors may watch for a move below 30 which, in the previous uptrend, would have gotten them out at the end of 2007.

If the market starts to move higher again, pretty soon you will start hearing hoopla about the S&P reaching 1500, the Dow closing in on 14,000, etc. Don't be fooled. Keep your eye on the NYSE Bullish Percent. If it continues to slump, the 2009 rally will not last much longer.

- Chip Anderson

P.S. I would love to meet you at one of our upcoming SCU Seminars. During the SCU 101 seminar, I go into much more detail about Bullish Percent Indexes, Sector Rotation, and how to use all of the various tools on our website. We have upcoming seminars in Dallas, Orlando, Seattle, LA and New York. Click here for details. I hope to see you soon!

One month ago, I discussed the increased risk of holding gold as key price resistance was being tested with a long-term negative divergence on the MACD present. That was a sign of slowing momentum and that, combined with price resistance, simply tells us to grab profits and respect the resistance - at least until gold makes the breakout. Well, the breakout was never made. In fact, take a look at the following two charts.

The first chart is how gold looked one month ago:

Now let's fast forward to show that resistance did, in fact, hold back the bulls and the slowing momentum and overbought conditions resulted in an approximate 7% drop that has now sent gold back much closer to key price and trendline support levels:

After flirting with $1800 per ounce, gold has fallen back to Friday's $1679 level. Note on the chart above that initial support resides at $1675. If that level doesn't hold - and it may not - more significant price support and a key trendline both coincide in the $1615-$1640 per ounce range. I'd expect that basic risk management would certainly begin to favor the bulls once again at those prices.

You can buy the metal or an ETF like the SPDR Gold Trust Shares (GLD) to attempt to profit from swings in the price of gold. Another way to potentially benefit is to buy the stock of a gold miner. One gold miner looks interesting to me and I'm including it as my Chart of the Day for Monday, November 5th, 2012. It's provided FREE and you can learn more by
CLICKING HERE

Lumber prices surged Wednesday after the devastation on the east coast. [I live in New Jersey which was hit especially hard]. There's a lot of rebuilding that's going to be needed as a result And that's going to require a lot of lumber. Lumber has in fact been rising over the last year as the housing industry has recovered. The chart below shows a positive correlation between the price of lumber and Dow Jones Home Construction iShares (green area) over the last four years. The homebuilding index bottomed last October and has since risen to the highest level in four years. That also began a strong rally in the price of lumber (see arrows). The chart also shows lumber on the verge of breaking out of a large "ascending triangle" pattern. [An ascending pattern is identified by a flat upper line and a rising lower line and is usually a bullish pattern]. The improvement in housing and this week's east coast damage should combine to make the price of lumber a lot more expensive. One way to participate in that rally is to buy lumber futures. Another way is to buy stocks tied to lumber.

Stocks surged on Thursday and even followed through on Friday morning, but strength did not last long as selling pressure kicked in after the initial pop. Perhaps some pre-election jitters produced this classic pop and drop. Whatever the case, the Russell 2000 hit stiff resistance near its channel trend line and remains in a short-term downtrend. The chart below shows the index zigzagging lower since mid September. $RUT found support at the 200-day moving average and the late August consolidation (yellow area). Thursday’s surge off support was impressive, but follow through is what separates one-hit wonders from trend reversals. A follow through breakout is needed to reverse this seven-week slide and signal a continuation of the bigger uptrend, which has been in place since early June.

Click this image for a live chart.

The indicator window shows the $RUT:$SPX ratio triangulating the last four months. A potential higher low could be forming in October, but we need to see a breakout to signal relative strength in the Russell 2000 (small-caps). This would be positive for the overall market. Note, however, that a break below the October low would signal renewed relative weakness in small-caps.

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